What is the unamortized bond premium?

The gap between the face value and the selling price of a bond is known as the unamortized bond premium. The bond issuer must still return the entire 100 cents of face value at par even if the bond is sold at a discount, such as 90 cents on the dollar. This interest amount represents a liability for the issuer since bondholders have yet to receive payment for it.

An Understanding of Bond Premium Unamortized

The amount that the bond is valued over its face value is known as the bond premium. Bond prices rise in an environment where interest rates are lower than they are now. This is because the market interest rate exceeds the set coupon rate on existing bonds.

Bondholders demand a premium in the market as compensation since they hold bonds with higher interest rates. What’s left over after the issuer has written off the bond premium as interest costs is the unamortized bond premium.

For illustration purposes, assume that a bond issuer offered bonds with an annual 5% fixed coupon while interest rates were 5%. After a while, interest rates dropped to 4%. New bond issuers will issue the reduced-interest-rate bonds. Investors who want to purchase bonds with higher coupons will have to pay a premium to encourage higher-coupon bondholders to sell their bonds. In this scenario, the unamortized bond premium ($90) is the difference between the bond’s selling price and the par value if its face value is $1,000 and it sells for $1,090 after a drop in interest rates.

The portion of the bond payment that will be amortized (written off) against future costs is known as the unamortized bond premium. This bond’s amortized amount is counted for interest expenses. The bondholder has the option to amortize the premium or utilize a portion of it to lower the amount of interest income that is subject to taxes if the bond pays taxable interest.

Particular Points to Remember

Amortizing the premium is usually advantageous to investors in taxable premium bonds since it may be used to offset bond interest income, lowering the taxable income the investor must pay for the bond. The annual amortized premium amount is deducted from the taxable bond’s cost basis.

The bond investor must amortize the bond premium if the bond pays tax-exempt interest. The taxpayer must lower their basis in the bond by the amortization for the year, even if this amortized amount is not deductible for calculating taxable income.

The bond issuer records an unamortized bond premium as a liability. This item is documented in a unique Unamortized Bond Premium Account on an issuer’s balance sheet. The amount of bond premium that has yet to be amortized or charged off to interest expense throughout the bond’s life is recognized in this account by the bond issuer.

Example: Calculating the Unamortized Bond Premium

The bond price is multiplied by the yield to maturity (YTM), and the resulting amount is deducted from the bond’s coupon rate to determine the amount that must be amortized for the tax year. The yield to maturity, using the example above, is 4%.

• $1,090 x 4% = $43.60 is the bond’s selling price times the yield to maturity (YTM).
• This amount is deducted from the coupon amount (5% coupon rate x $1,000 par value = $50) to arrive at the amortizable amount of $50 minus $43.60 = $6.40.
• A bondholder may deduct $50 from interest income for tax purposes, making $50 minus $6.40 = $43.60.
• After a year, the unamortized premium is $90 (bond premium less the $6.40 amortized amount), or $83.60.
• Since $6.40 of the bond premium has already been amortized for the second tax year, the bond’s cost basis is $1,090 minus $6.40 = $1,083.60.
• For Year 2, the premium amortization is $50 minus ($1,083.60 x 4%) = $50 minus $43.34 = $6.64.
• The unamortized premium, or the remaining premium after the second year, equals $83.60 minus $6.64, or $76.96.

You may compute the same for the remaining three years, assuming the bond matures in five years. For example, in the third year, the bond’s cost basis will be $1,083.60 minus $6.64, or $1,076.96.

Conclusion

• The net difference between a bond issuer’s selling price and the bonds’ real face value at maturity is known as the unamortized bond premium.
• Issuers must pay the unamortized bond premium since they have yet to deduct the interest charge, but it will ultimately become payable.
• The Unamortized Bond Premium Account is a liability account that reports unamortized bond premiums on financial statements.